January 26, 2009

One of several memes we've heard over and over now to the point of becoming conventional wisdom is that "the tax rebates didn't work".

Now, before you think I'm simply on one side of a partisan debate, let me say first I think taking sides itself a mental error that leads to further errors. I'm not on any side, unless it turns out Obama keeps doing everything right as we go along. I think most of the large publicized pieces of spending in the stimulus proposal are good ideas, and good together as a large package (though not bringing enough timely stimulus in 2009, see why speed matters). My view is that A) we need many different kinds of stimulus, both government spending and tax cuts, but that B) the stimulus, however large, will not suddenly bring us into a roaring recovery, that C) the deep recession is likely to last for years in terms of feeling like we are in a recession. In certain ways, all of this is beside the point. There are fundamental reasons why America cannot have another golden age where it is always wealthier than other nations. And worse, it's even likely that the unemployment and economic challenges we face cannot be fixed completely through most kinds of government stimulus -- that the temporary setup where China grew rapidly while holding down American inflation and interest rates (by providing cheap goods and exporting their excess savings to us also) has played out to an end, bringing back more normal economic turbulence. Only special, unique conditions like those of the 1950s or 1990s can create economic ease, and only temporarily. (I'll post about this interesting question later.)

But today, it's popularly understood we are under threat of another Great Depression. Some even speculate we may face a Greater Depression, due to the profound debt overhang weighing on our economy.

This housing price bubble was more pronounced than any before, implying a deeper fall and heavier than normal fallout. Arrayed against this danger is a more knowledgeable and aggressive Federal Reserve and Federal Government than in the 1930s.

Most people now understand there is a feedback loop of job losses increasing fear -- which in turn leads to further pullbacks in consumer spending, creating more job losses.

So the public at large widely understands that this recession could deepen and keep deepening without intervention.

And while the two sides of the debate argue about what kind of stimulus will "work", the real picture is both more complex and more simple than commonly presented by major columnists, news reports and economists.

It's more simple in that ultimately all the financial crisis is one simple process -- the inevitable fallout of an enormous decades-long world-wide credit bubble. Another element in the popular view of what is happening -- "letting Lehman Brothers fail worsened the crisis" -- is also false. The whole picture of a "credit crisis" worsened by "letting Lehman fail" presumes we could always have grown debt, ever more and more -- more mortgage debt, higher debt to income ratios, more consumer spending and less saving, without limit. Thinking that allowing Lehman to fail caused more crisis implies that if Lehman was saved, the crisis might pass, and things could continue as before the crisis. In this view, a "crisis" or "shock" happened which should and could have been contained. So the story goes, or went, with the support of some prominent voices.

Nevertheless, there is more and more recognition spreading that we had a more genuine problem of a true out-of-control bubble -- that the housing bubble is part of a more fundamental story.

The implication of having a real bubble is that it will indeed eventually burst and collapse, and that falling house prices are not just caused by foreclosures or psychology alone -- are not merely a by-product of some other chance financial events.

Saving Lehman Brothers would have been like patching one significant hole in a slow motion bursting bubble -- it would not stop other from holes opening and growing in the ever thinner bubble surface.

So the story is more simple than often portrayed -- we ran up debts much faster than our average incomes grew, leading to an inevitable hitting-the-wall moment.

By late 2004, there were no actions by the Fed, by the Federal Government, by regulators, by anyone, that could have made any difference. House prices had already become out of reach of average families with conventional mortgages in too many places.

If it hadn't been New Century Financial hitting the wall first, it could have been American Home Mortgage Investment Corp. If it hadn't been Bear Stearns collapsing before Countrywide, it would have been Countrywide collapsing before Bear Stearns.

If Lehman had been saved, at you and your children's expense, instead of at the expense of various investors, that would not have saved Washington Mutual (as an independent bank), IndyMac, Wachovia, Merrill Lynch, etc.

One of the more disturbing political processes I've seen up close is the evolving political story of the TARP. At this point the story has evolved to say the initial phase of TARP under Hank Paulson failed and was opaque. But Paulson originally presented TARP as a way to stop the ongoing crisis of banks failing and our financial system appearing in danger of collapse. This was not something that could be easily talked about -- even if more Congressmen understood the real picture, it tends to increase panic for many leaders to talk of most well-known banks failing. Instead Paulson had to warn simply of a general financial crisis intensifying. TARP, then, was easy to re-define into the ultimate political football. When Paulson flailed about at first due to the impossible contradictions of his initial plan of buying bad mortgage securities, and then later finally followed the mainstream advice of most economists to inject funds directly into banks -- the plan that was actually used -- he gave a characteristically brief announcement, perhaps presuming it would be understood.

But while his announcement made sense to economists and well-read followers of the situation, how many average people understood the whys and hows of the new plan? While Paulson efficiently and effectively shored up the surviving banks -- and did so openly and in full view -- it seemed to me everyone would be pleased the best possible plan had been enacted. The best possible outcome to that moment had been found.

But Paulson's actions were subsequently portrayed as opaque ("lacking transparency") and against the will and intent of Congress!

I wonder if many of our elected representatives realize that many average people are not fooled at all by the political rhetoric. Many more people than they realize are quite aware this was the Big One, and more banks were heading to the chopping block. More people than they'd guess have paid attention to the fact the big bank failures stopped after TARP, at least those with names everyone knew, the kind that kept everyone on edge.

The initial TARP money stopped the accelerating large bank failures (Washington Mutual and Wachovia were the last for a while), and reduced the panic, just as it was proposed to do.

TARP was initially proposed to "stabilize the financial system." TARP indeed did so, to the extent possible with that amount of money. But "stabilize the financial system" is too vague a term it turns out, and has been re-defined quite easily to mean things other than what close observers understood.

Often we'll hear a bit on a newscast of someone who wonders why TARP didn't stop the financial difficulties entirely. Some even believed TARP was meant to also save homeowners near foreclosure. This was certainly a communications mess.

The initial TARP was successful in a sense that mattered. A panic that threatened to escalate to complete collapse of all large banks was averted, along with the psychological damage that would have added against already weakening confidence.

TARP so far has been similar to strapping parachutes onto the passengers (banks) falling out of the disintegrating airplane of banks-that-took-risky-bets.

Those with parachutes are still drifting downward of course, but for now they are still breathing. Some banks receiving funds weren't in that shaky airplane, but rather stood safely on the ground, with few risky bets, and are in far better shape.

Ideally those sounder banks could actually buy out the weaker, poorly-managed banks at low prices, resulting in the best possible outcome for the nation.

But some in Congress actually objected to the beneficial effect of well-managed banks using TARP funds for acquisitions!

Does it occur to many in Congress that their political rhetoric is part of why the level of trust for Congress is so low? Even when we don't know exactly what the political misdirections are, we intuitively sense we often aren't hearing the real story.

Much of Congress played the blame game -- trying to make it appear the other partisan side was responsible for what few wanted to admit was inevitable.

It's estimated that American banks would need more than $1T (that's trillion, and some estimate more than $2T) to be effectively re-capitalized to the level of being able to do significant lending without worrying about failing in the next few years. (see George Soros on this)

Why so much? Because the realistic losses from the credit bubble (mortgages, credit cards, commercial real estate lending, etc) are expected to be this much or more when we aren't pretending things are better than they are. But the jobs of the Fed chairman, Treasury Secretary, and other public officials are to instill confidence. They must acknowledge things are only as bad as we can see in the rear view mirror, and by the way -- don't panic.

The gigantic losses of banks and across the economy are the result of the end of a decades-long credit bubble.

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So....the tax rebates of summer 2008... Seems like a while ago, doesn't it?

Yes, it seems this recession didn't drop off as steeply in its early months as normal. During the Summer of 2008 (months 5-8 in the graph), when things should have deteriorated more rapidly....the pace of the downturn was somehow slowed....business failures were slowed, bankruptcies were slowed, bank withdrawals (runs) were slowed, mortgage defaults were slowed, housing sales held up a little better....

What we know is the powerful recession we are in acted like a mild recession for many months, quite different from the typical pattern.

Did the tax rebate anticipation and arrival hold off the real power of this recession for many months? If so, did this slowing of the downturn help the "crisis"?

Well, the recession, like all recessions is in part psychological, and depends on confidence. The crisis is in part fear, and fear is the most powerful force in it, able to stop consumers, businesses, banks and jobs in their tracks.

Fear tends to feed on itself. The unusual staying power of confidence in the first 7 months of the recession held off a lot of effects. By slowing the downturn, the level of fear was held lower than it would have been and the "crisis" unfolded more slowly, giving the Fed and the Treasury and the FDIC more time to plan and act and learn.

We know the powerful driver of the recession is the collapsing housing bubble, and the associated consumer debt bubble and commercial real estate bubbles. The gasoline price spike added a powerful drag during the summer, and without rebate checks to offset the high prices, would likely have collapsed consumer spending much faster during the summer. The other powerful factor in any recession is the level of confidence. Consumers felt more confident for many months than is typical in a strong recession like this one.

Why? Well confidence is a combination of expectations and news and popular stories about what is happening. Consumers were told the stimulus was coming and it was thought it would help. Both the tangible reality of extra cash in our pockets and the belief it would help buoyed confidence.

The Tax Rebate of 2008 was the cause of the gentleness of this recession for months, in spite of the other huge forces that would make it a powerful recession, as is now evident.

We are also told the tax rebate failed because most of it was saved.

Consumers, instead of spending like nothing was happening, chose to pay down part of their credit card debts or save a good part of their rebates. Because they saved more, they've felt a little less pressure and a little safer ever since (than they would have at without that extra savings). Because we all have a little more money at hand still, it's likely we choose to eat out or buy discretionary items just a little more often than we would otherwise.

Put another way, as we have cut back spending, we haven't cut back as much as we would have without that extra in our pockets (or lower card balance).

Do the particular theoretical "multipliers" for different categories of stimulus spending favored by those opposed to tax cuts measure the effect of reducing fear and adding residual extra spending months later? If your guess is no, I bet you are right.

Having saved more, many of us now are spending a little more, supporting each others' jobs just a little better than we would have without that summer 2008 rebate.